Britain is “uniquely at risk”, mainly because the Government has spent too much during the good times. The country faces house price falls of as much as 10%; while unemployment will rise to a ten-year high, with 200,000 people losing their jobs over the next 18 months.

Nice to see the world’s economic institutions are catching up to reality. But the OECD is still too optimistic…

The OECD has warned that the UK is in big trouble. It reckons the Bank of England needs to cut interest rates to 4.25%, but says it must hold off until next year because of inflation risks. The Bank will be announcing its decision on interest rates later today, and is widely expected to keep them on hold at 5%.

Why the government should be spending more right now but can’t

It also says that the Government probably shouldn’t be pulling in the reins in terms of public spending. The idea is that when times get hard, the Government spends a bit more to keep the economy ticking over until the private sector gets back on its feet.

But of course, this isn’t really possible, because the Government has bled the country dry during the good times. Gordon Brown has taken money that would once have gone into private sector pensions (which would have enabled more of our citizens to take care of themselves in the future, rather than relying on the state), borrowed a whole load more, and then sprayed it all over the public sector to almost no apparent effect at all (if you still have trouble believing this, read Squandered by David Craig – do remember to take your blood pressure pills first though).

As the OECD puts it, a little less bluntly: “The Government’s options have been limited by excessively loose fiscal policy in past years when economic growth was strong.”

It’s unusually tough talking from this type of body. Of course, the Treasury said the OECD was wrong. “The UK economy remains strong, and is well-placed to get through these global problems.” All I can say is, it’s little wonder that British consumer confidence is at a record-low ebb.

Those in power – both in the public and private sectors – of our key economic institutions seem to have one reaction to the credit bubble popping. That’s to stick their fingers in their ears and sing “la-la-la, I can’t hear you.” If it’s not Alistair Darling blethering about the UK being “well-placed”, then it’s any number of banking chief executives effectively saying: “Everything’s fine, our lending book is top notch, and even though the housing market is in meltdown, we will somehow be the one bank that can get through it unscathed. By the way, can any of you shareholders spare another few billion? No, don’t form a queue, people might get the wrong idea…”

A 10% fall in house prices? We should be so lucky

The unfortunate truth is that in fact, the OECD’s predictions that house prices could fall by as much as 10%, and that unemployment will rise by just 200,000, still seem quite tame.

Plenty of mainstream forecasters are now predicting falls of at least 10%. And during the 1990s recession, unemployment actually rose by closer to one million. And despite the increasingly desperate claims of the optimists, it is looking more and more as though this downturn could be much worse than the one in the 1990s.

One of the reasons behind yesterday’s 87-point drop in the FTSE 100 was a particularly worrying piece of economic data. The Chartered Institute for Purchasing and Supply released its services sector survey for May. The data showed that the sector shrunk for the first time in more than five years.

This is bad news. The service sector accounts for about three-quarters of Britain’s economic growth. But even worse was the news that employment saw its biggest contraction since records began in 1996, “with hotels and restaurant staff bearing the biggest brunt,” reports Edmund Conway in The Telegraph. And yet prices charged continue to rise. Companies are also more pessimistic than at any time since records began.

And all of this is already happening when we’re still at the start of the fall-out from the housing crisis – as the Halifax reported this morning (see below), prices are now down 3.8% year-on-year. The number of people in negative equity is creeping higher by the day.

It doesn’t matter what the Bank does today, or how many warnings the OECD gives out. The British economy is headed for recession. The only question is – how bad will it get?

Turning to the wider markets…

US stocks were mixed, with warnings that Moody’s may downgrade two major bond insurers (Ambac and MBIA) hanging over the market. The Dow Jones Industrial Average fell 12 points to 12,390. The wider S&P 500 was flat at 1,377, while the tech-heavy Nasdaq Composite gained 22 points to 2,503.

In Asia, the Nikkei 225 fell 0.7% to close at 14,328, as falling crude oil prices hit commodity trading groups. In Hong Kong, the Hang Seng climbed 0.2% to 24,161.

Brent spot was lower again this morning, trading at $121.02, with crude in New York trading at $122.25. Spot gold was at $875 an ounce. Silver was trading at $16.67 and Platinum was at $1,987.

Turning to forex, sterling was trading at 1.9515 against the dollar, and at 1.2636 against the euro. The dollar was last trading at 0.6478 against the euro and 105.87 against the Japanese yen.

And this morning, the Halifax reports that house prices fell by 3.8% in May compared to the same month last year. That’s the biggest annual drop since April 1993, when prices fell 2.4%.

Source: Why the Bank of England Can’t Save Britain from Recession

Take oil. As Gabriel and Al mentioned in Money Morning earlier this week, the correction is on. Oil was down another two dollars in U.S. trading around US$122. And it wasn’t even the thundering of George Soros in front of Congress that scared speculators out of their positions, either.

High prices, as the saying goes, are the cure for high prices. “Cure” may not be the best word, though, especially if you’re an airline company or a car maker. Here in the States, United Airlines announced it would cut its domestic service Ted (the equivalent of Jetstar), cut 1,100 jobs, and retire about 70 planes, including the lumbering, old, creaky 747s that fly the Sydney to LA and Sydney to San Francisco route.

Why the drastic measures? Jet fuel prices are up 89% in the last year. High prices. The auto industry is finally reacting to high prices as well. General Motors announced it would close four truck and SUV plants in the U.S. and shed 10,000 jobs. GM’s capacity to build gas-guzzling trucks will decline by 35%.

It’s been a long time coming. And while GM makes fewer bigger cars, the company plans to make a new smaller, more fuel-efficient car. It also plans to get into the plug in hybrid market with the Chevy Volt.

Jets and cars and oil prices. Demand is finally destroyed by high prices. Of course the demand destruction in the transportation and travel market means a contraction of an economic activity. It also means, as GM’s CEO Rick Wagoner suggested, a permanent shift to a world where cheap energy is no longer the assumption. Maybe we’re moving toward a different living arrangement after all. Hmmn.

Much too late in the game, Fed chairmen Ben Bernanke is talking up the dollar, as if kind words were any replacement for a real yield. Bernanke is trying to talk people out of being worried about the very inflation his monetary policy has caused worldwide. He told listeners to a commencement speech at Harvard that heightened inflation expectations by the public are a “significant concern.”

But don’t worry, he continued. This ain’t nothing like the 70s. It’s all good. Nothing to see here. Move along. Go away. Shut up. Goodbye.

“We see little indication today of the beginnings of a 1970s-style wage- price spiral,” is what Bernanke actually said. “The overall inflation rate has averaged about 3.5 percent over the past four quarters, significantly higher than we would like but much less than the double-digit rates that inflation reached in the mid-1970s.”

Well it all depends on how you measure inflation, doesn’t it? The Fed probably under reports actual inflation. But it’s also probably true that inflation hasn’t yet reached the wild levels of the 70s. For that to happen, expectations have to begin driving consumer behaviour (trading cash for tangible goods while the cash retains purchasing power) and monetary policy must become even looser to respond to tight credit markets or over-indebted consumers.

Do you really think the Fed will be raising rates this year? Not likely, with credit markets still tied up in knots and house prices in the U.S. still falling. This is one reason why we think the Aussie dollar is still a good bit to hit parity this year with the greenback.

Speaking of Australian interest rates, just when you thought it was safe to begin thinking of lower rates, more mixed signals for the RBA. The Australian Bureau of Statistics reported yesterday that Aussie GDP grew at 0.6% in the first quarter. That comes out to an annual rate of 3.6%.

That growth rate is 0.6% higher than what economists surveyed by Bloomberg expected, although it’s lower than last year’s rate of 3.9%. This is exactly the kind of economic growth that’s led the RBA to the conclusion that inflation will grow at 4.25% until some time in 2010.

Not so, says the OECD! The OECD assures us that inflation will slow to 3% by the end of next year, a full year earlier than Australia’s own central bank expects. Why? Because, “economic activity is likely to slow to below 3% in 2008 and 2009 because of tighter financial conditions and the worsening external environment. This should ease pressures on the labour market and bring inflation down to under 3% by the end of 2009.”

Well there you go. Despite all evidence to the contrary, the OECD says it will be so.

We know the DR has been a little thin on analysis of the Aussie market and the economy this week. We promise to resume our full coverage upon our return next week. Until tomorrow…

Dan Denning
The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Source: Inflation Hasn’t Yet Reached the Wild Levels of the 70’s

Inflation in the Eurozone is running at a 16-year high. And on Wednesday, the Organisation for Economic Cooperation and Development (OECD) boosted its inflation prediction to 3.4% in 2008, well above the ECB’s 2% target.

Policymakers voted to keep the central bank’s key interest rate at 4.0%. The ECB also held its two other key rates – the deposit rate and the marginal lending rate – unchanged at 3.0% and 5.0% respectively, the AFP reported.

“The ECB is trapped,” Joerg Kraemer, chief economist at Commerzbank AG (OTC: CRZBY) in Frankfurt, told Bloomberg News. “We have the problem of persistently high inflation rates, while growth is weakening. I expect them to keep rates on hold for a very long time.”

But with prices for food and fuel soaring across the Eurozone, merely holding rates steady might not be enough for the hawkish ECB.

A rate increase next month “is not excluded,” Trichet said, but “is not certain,” adding that the ECB never “precommits” to a move and that the policymakers would only make a final decision on the day they meet.

Separately, the Bank of England also voted to hold its key interest rate steady at 5.0%.

“Inflation is painfully high and the negative effect on purchasing power is squeezing the life out of the [Eurozone] economy,” Ken Wattret, an economist at BNP Paribas SA in London told Bloomberg. “It now looks increasingly like a consumer recession is unfolding.”

Economic growth is slowing, as even Germany, the European Union’s largest economy, has experienced some softening and an up-tick in unemployment. The OECD revised its growth projection down to just 1.7 % this year and to 1.4% in 2009, AFP reported.

Contrasting Currency Effects

Europe’s central banks have clearly made inflation their priority, a stark contrast to the U.S. Federal Reserve’s aggressive rate-cutting campaign. The Fed has slashed 325 basis points from the key Fed Funds rate since mid-September. The key U.S. interest rate now stands at just 2.0%, well below that of its European counterpart, putting more pressure on an already weak greenback.

Comments from Fed Chairman Ben S. Bernanke on Tuesday acknowledged the weakening effect the U.S. rate cuts have had on the dollar.

Speaking via satellite at the International Monetary Conference in Barcelona, Spain, Bernanke said the Fed is working with the Treasury to “carefully monitor developments in foreign exchange markets.” The Fed Chair said he was aware the effect of the dollar’s decline on inflation and price expectations, Bloomberg News reported.

It is widely expected that the Federal Open Market Committee (FOMC) will vote to remain on pause at its next meeting scheduled for June 24 – 25.

Bernanke’s comments gave a slight boost to the dollar, only to be reversed by Trichet’s allusion to a possibly ECB rate hike in June.

The dollar lost ground against the euro to trade at $1.554 in mid-morning trading today, down from $1.547 at the New York close the day of Bernanke’s remarks.

Source: ECB Stands Firm Against Inflation

In this week’s Outside the Box we continue with what I mentioned a few weeks ago: agricultural needs are going to be a new and important force in the world and when coupled with energy may shift the balance of power in the world in strange a different ways.

When, as Niels points out, Afghanistan poppy farmers are shifting to wheat farming, the world is truly a different place. I think you will find the research he has done to be truly worth a few minutes of your thinking time.

And as a preface, I was reminded a little while ago that a Financial Times headline story last Friday mentioned that China is buying African farmland and building massive amounts of railroads and infrastructure to get grains to the market. I have long been bullish on African farmland. This week’s OTB will tell you why.

“There is nothing so disastrous as a rational investment policy in an irrational world,” John Maynard Keynes. You just know that something is astray when Afghan poppy growers begin to switch from opium to wheat.

According to the Independent newspaper here in the UK, that’s exactly what is now happening. I have no desire to enter into a pound for pound risk/reward analysis of producing wheat versus opium. However, the consequences of the rapid rise in energy and agricultural commodity prices are far reaching and perhaps not as well understood as they should be. That is the content of this month’s letter.

The Silent Tsunami

My story begins with Al Gore. While most of us lulled ourselves into the belief that he was onto something when he tried to convince us that global warming (or climate change, as I prefer to call it) was the most formidable challenge facing this planet, a silent tsunami¹, also known as the global food crisis, began to develop and is now threatening to undermine global political and economic stability, the latter of which has been key to the benign financial markets we have all benefited from in recent years.

According to the World Bank, just over 1 billion people live on one dollar or less per day. People in the poorest countries in the world spend 80% of their income on food. So when you and I have hardly noticed that the bread we pick up from the local bakery has doubled in price over the past year, it is because only 10-15% of our budget is spent on food items². In many emerging economies the number is much higher. Chinese consumers spend 28% of their income on food. In India it is 33%. If you want to know how much it is in your country, go to:

http://www.ers.usda.gov/briefing/cpifoodandexpenditures/data/2006table97.htm.

There are three food staples in the world today which dwarf all other food ingredients in terms of importance. They are (in alphabetical order) corn, rice and wheat. As you can see from chart 1 below, they have all experienced rapid price appreciation since last summer. What is it that has driven this price explosion and what does it mean to financial markets? As with most things in life, there is no simple explanation; a number of factors have conspired to create a situation which is exceptional but also destabilising and hence dangerous.

It Is The Bio-Fuel Policy Stupid!

The explanation given by most commentators is the bio-fuel policy currently being pursued by the Bush administration in Washington. The policy is driven by a desire to unlock the United States from its rising dependence on imported crude oil. The problem, as Bush and his government have been slow to recognise, is the stupidity of the policy in its current form. Let’s back that claim up with some hard facts.

In the United States, corn (better known as maize over there) is the primary ingredient in ethanol production although wheat and soybeans are also used. According to a recent UN report, it takes 232 kg of corn to fill an average 50 litre car tank with ethanol – enough corn to feed a child for an entire year. It is estimated that almost 20% of total US corn production will go towards ethanol this year and the number is set to rise to 45% by 2015³.

The problem with corn is that it is low on carbon hydrates, which is where the energy comes from. Instead, American ethanol producers rely heavily on fertilisers with the energy being extracted from the nitrogen in the fertiliser. This is an inefficient and very costly approach – in particular in an environment of rising energy prices because crude oil and/or natural gas are major ingredients in fertiliser production. 33,000 cubic feet of natural gas are required to produce just 1 ton of ammonia!

So what does all this mean? According to estimates from Goldman Sachs, the cost of ethanol from corn is now over $80 per barrel, it is about $145 from wheat and over $230 from soybeans. Other countries recognised this problem a long time ago and use crops with higher carbon hydrate content. In the Philippines they use coconut oil and the Brazilians use sugar cane. Goldman reckons that the cost of one barrel of ethanol based on sugar cane is about $35. So why not import sugar cane from Brazil instead of using corn? One simple answer: Brazilian farmers do not vote at American elections. Idaho farmers do.

Are Investors To Blame?

There is no question that the US bio-fuel policy which, by the way, is now being copied in other parts of the world including the EU, has to take its share of the blame. But it is by no means the only reason for the food crisis. The next culprit on my list is our very own industry – investors of all kinds. In recent years there has been rising demand for commodity-linked investment products from investors all over the world. Pension funds, hedge funds, mutual funds and private investors have all allocated more and more to commodities and, in recent months, demand growth has been explosive, as is evident from chart 2 below. It is estimated that the aggregate value of commodity-linked index funds now exceeds $200 billion, a very significant number in a not very large market.

More than 30 years after Japan’s only airliner program since World War II ended as a commercial failure, the country is making a multi-billion-dollar bet that it can succeed in the jetliner market.

Japan’s Mitsubishi Heavy Industries Ltd. (PINK: MHVYF) has unveiled a plan to develop a “regional” jetliner for use by airlines all around the world. The controversial project gained global credibility in recent weeks after analysts began to speculate that Toyota Motor Corp. (TM) – the world’s No. 1 automaker by sales – would join the development team. Toyota subsequently confirmed its involvement, announcing plans to take a 10% stake in the venture and injecting $67 million to help get the initiative off the ground. The Japanese government is backing the program.

It’s a big gamble for Mitsubishi and its partners: The regional airliner market is right now dominated by Bombardier Inc., of Canada, and Embraer (Empresa Brasileira de Aeronautica SA) (ERJ) of Brazil. And firms in both Russia and China – each with a major U.S. corporation as a partner and co-pilot – already have targeted this market, and have a solid head start on the Mitsubishi team.

Still, the potential payoff is hefty enough to warrant the risk. Such key global trends as rocketing fuel prices, soaring global travel, fast growth in Asia, Latin America and the Middle East, and ongoing problems with major air carriers across the world are stoking worldwide demand for efficient, economic regional jets. And that demand could persist until 2030, many experts predict.

“In terms of the macro picture, demand is there for this type of jet,” Mizuho Investors Securities Co. Ltd. senior analyst Yuichi Ishida told the Reuters news service. “Money-losing regional routes could turn profitable by using them. But the real question is whether there is room left in this market for Mitsubishi Heavy.”

To date, the so-called NAMC YS-11 – a turboprop airliner built by a Japanese consortium – is the only commercial aircraft made in Japan in the post-World War II era. The program was initiated by Japan’s Ministry of International Trade and Industry in 1954. The aircraft was rolled out in 1962 and production ended in 1974 – hardly qualifying it as a “success” from a financial standpoint.

Toyota’s Desire to Fly

Toyota said its motivation was primarily patriotic – the Mitsubishi jet is being backed by the Japanese government, which is searching for ways to for its smallish aerospace business to become more of a global player, especially after losing other industries to South Korea and China.

Toyota – which edged ahead of General Motors Corp. (GM) in the first quarter to become the world’s top-selling automaker – said it also would be looking for ways to adapt the technological know-how developed in its aerospace activities to its core automaking business. That’s not just an empty claim made to justify its diversification into the aerospace sector: The Mitsubishi MRJ70 (70 seat) and MRJ90 (90 seat) jetliners are to be the first regional jets to make extensive use of high-strength/lightweight “composite” materials, such as those found on the new 787 Dreamliner being developed by U.S. aerospace giant, The Boeing Co. (BA).

Although it hasn’t built a commerical aircraft in decades, it is an experienced subcontractor in that area, and is a veteran defense contracting firm. For example, Mitsubishi already is a key manuacturing partner on the long-range Boeing jet. And it has experience building such military aircraft as the F-1 fighter, T-2 trainer – both supersonic jets that the company built on its own – and the F-2 fighter, a Japanese-built version of the U.S. F-16 Fighting Falcon that was produced in partnership with Lockheed Martin Corp. (LMT)., the No. 1 U.S. defense contractor.

Toyota, too, has some experience, and already operates a small aerospace research team. Analysts say that venture could easily take flight and become a major business operation. That’s just what happened with Toyota’s robotics business, which started out as a fairly tiny research operation, but today is one of the company’s better-known businesses outside its core auto operation.

Honda Motor Co. (HMC), Toyota’s chief rival in Japan, already has expanded into the aircraft business; its futuristic seven-seater HondaJet light business jet has garnered heady praise for its advanced design and elegant lines. The company was supposed to start taking orders for the airplane sometime this month.
Toyota’s investment in the Mitsubishi jet is the largest of any company outside the Mitsubishi corporate network, or “keiretsu” of related companies. Other backers include domestic Japanese trading companies and the government-supported Development Bank of Japan. Foreign suppliers also will be involved.

To Market, To Market

Why is Mitsubishi – Japan’s largest producer of machinery – getting into the airliner business? In a word: Opportunity.

Over the next 20 years, Boeing itself is forecasting that air carriers worldwide will need to acquire 28,600 commercial aircraft of all types – with a potential value of $2.8 trillion. The Boeing forecast is generally viewed as the world’s best analysis of the future global market for commercial airliners and cargo aircraft.

The huge revenue potential in the global airliner market – combined with the low number of viable competitors and the high barriers faced by new potential entrants – is a big reason that Money Morning’s investment gurus have repeatedly mentioned Boeing as a promising global investment for years to come.
During that same 20-year stretch addressed by Boeing’s market forecast, China will have to buy 3,400 airliners, a requirement worth $340 billion. That will make China the fastest-growing airliner market in the world, and will also rank it as the biggest market outside the United States for new commercial airliners. In fact, if you average it out, from China alone you’re talking about sales of $17 billion a year for the next two decades.

This staggering shopping list will include the globetrotting tarmac queens being built by Boeing and European rival Airbus SAS.

But global forces also are revving up demand for regional jetliners, like those being dreamed up by Mitsubishi.

According to Mitsubishi, the world’s airlines will order 5,000 regional jets over the next two decades as global carriers seek out fuel-efficient airplanes for shorter routes and developing nations expand their airliner fleets to fuel economic growth.

That’s not an arbitrary figure, either: The company spent several years analyzing the market and projecting the potential demand for the jet, and designed the specifications specifically around its findings. The plane will be:

• Small, so it can fly out of regional airports.
• Made of lightweight composites to make it strong and fuel efficient.
• Fast (with cruisng and maximum speeds of between 0.78 and 0.82 times the speed of sound, according to published reports).
• Profitable to operate, carrying 70 to 90 passengers, depending upon the model.
• And with a good range – 920 nautical miles for the base model, although extended-range (1,400 nm) and long-range (1,960 nm) versions will be available.

“Mitsubishi Heavy has always been just a partner of Western aircraft makers,” Mitsubishi Heavy President Kazuo Tsukuda said at a news conference that talked up the company’s pet project. “Now we want to take advantage of changes in the marketplace such as high fuel costs and a greater need for environmentally friendly aircraft.”

On that date, the Financial Crimes Enforcement Network (FinCEN), issued a “financial advisory” dealing with Iran. FinCEN, a little-known bureau within the U.S. Treasury Department warned the world’s banks that if they do business with Iran, they do so at their own financial peril.

But the FinCEN advisory was no less an act of war, albeit undeclared, than an outright invasion of Iranian territory. In its advisory, FinCEN states that the entire Iranian banking system – including the Iranian central bank – represents an imminent risk to the international financial system.

FinCEN bases this assessment in part on a highly creative interpretation of United Nations Security Council Resolution (UNSC) 1803 (passed on March 3, 2008). In case you missed it, CR 1803 calls on member states “to exercise vigilance over the activities of financial institutions in their territories with all banks domiciled in Iran, and their branches and subsidiaries abroad.”

But the coup-de-gras for Iran came courtesy of another obscure agency. This agency is housed in Paris within the spacious bowels of the Organization for Economic Cooperation and Development (OECD). This agency’s name is the Financial Action Task Force (FATF). On February 28, it issued a statement reiterating its concern about continuing deficiencies in Iran’s anti-money laundering and terrorist financing laws.

A CR 1803 and the FATF’s mild rebuke are a far cry from stating the Iranian banking system is a clear and present danger to the world economy, as FinCEN now states. But that threat assessment is now official U.S. policy.

And if a bank with substantial connections to the United States carries out the transactions, they risk retaliation under the draconian sanctions authorized in Section 311 of the USA PATRIOT Act. Section 311 allows the United States to freeze the U.S. assets of any foreign bank deemed to have correspondent banking or other substantial relationships with specific banks FinCEN identifies.

What happens next? We need look no further than the experience of North Korea, which FinCEN listed as an imminent threat to the global financial system in September 2005. I’ll discuss that experience and the possible outcomes of FinCEN’s declaration of financial war on Iran in tomorrow’s A-Letter.

MARK NESTMANN, Privacy Expert &
President of The Nestmann Group
www.nestmann.com